Lennar (LEN) has acquired CalAtlantic in a near $10 billion deal which creates the largest homebuilder in the US. The deal rationale is driven by greater diversification and anticipated synergies and looks fairly good on paper. The deal has the potential to boost earnings quite a bit, as leverage ratios remain manageable as most of the deal is paid for in stock.
I like the deal but do believe that home builders should operate with discipline in terms of financial leverage, as the memories of a decade ago are still fresh, at least in my memory. I think that the 4% sell-off in Lennar’s shares is a bit of an exaggeration, certainly as the multiple is non-demanding. That said, I am not automatically buying this small dip as shares are still up 30% year to date, as the company is taking on a bit of leverage as well.
I like the deal, look forward to deleveraging and will be a buyer if shares dip a bit further, although allocations will be limited given the enormous cyclicality in terms of operating and financial a leverage, despite non-demanding multiples at this point in time.
A Big Deal
Lennar has reached an agreement to acquire CalAtlantic Group (CAA) in a $9.3 billion deal. While housing stocks are rising rapidly and an active debate is ongoing whether the market is still early in recovery, or whether we are late in the game, it is comforting to see that this is mostly a stock deal. Investors in CalAtlantic will receive 0.885 shares of Lennar stock, as Lennar will badume $3.6 billion in net debt.
Lennar will become the largest US homebuilder with sales of $18 billion on a trailing basis, controlling 240,000 sites across 1,300 communities in which 50% of the US population lives. The company will make 43,000 deliveries a year, which means that every one in fourteen houses will be delivered by the combination. Following this deal, Lennar has thrown D.R. Horton (DHI) from the number one position.
Greater scale and diversification are key reasons behind the deal. Cots savings are seen at $250 million of which $75 million will be realised in the fiscal year of 2018 already. The $250 million synergy amount should be realised as soon as the fiscal year of 2019, resulting in potential accretion of $0.50 per share .
A 27% premium for CalAtlantic’s shares seems fair and while investors stand to receive 0.885 shares of Lennar, they can elect up to $1.2 billion in cash as well at $48.26 per share.
How Fair Is The Deal?
Lennar is valuing CalAtlantic at $9.3 billion while Lennar itself is valued at $19.4 billion, roughly twice the valuation of CalAtlantic. This means that the combination is valued at $28.7 billion, which indicates that Lennar represents two-thirds of the total enterprise valuation.
This 67% exchange ratio is in line with the delivery ratio, as Lennar delivers 66% of the 43,672 deliveries over the past twelve months, yet Lennar´s backlog only makes up 54% of the total backlog. Lennar is responsible for just 62% of total revenues as Lennar´s average selling price of $399 thousand lags considerably to the average $473 thousand selling price of CalAtlantic.
On the bright side, Lennar posts gross margins of 22% which are roughly a point higher than CalAtlantic as Lennar has a very strong home-site position, controlling 72% of the nearly 244,000 sites which the combination will control.
The 27% premium offered for CalAtlantic, which works out to roughly a billion in dollar terms, can be justified by the synergies. If synergies of $250 million are capitalised at a market multiple of 18 times, based on a 35% tax rate, synergies alone can be worth almost $3 billion. This can easily justifying the premium offered for CalAtlantic.
Soft Market Reaction
The market has not taken the deal very well. Shares of Lennar fell some 4% from levels close its its highs, now exchanging hands at $55 per share. That move corresponds to a roughly $500 million reduction in the value of Lennar’s equity in response to the billion premium offered for CalAtlantic. Part of this might be the result that pro-forma net homebuilding debt will jump from 2.5 to 3.1 times EBITDA. This is the result of the fact that CalAtlantic operates with a higher leverage ratio.
Important for Lennar is to keep an eye on leverage as it too could not escape the impact of the 2008 crisis as the company was “forced” to sell >10,000 properties at just 40% of their stated book value at the time. That transaction had a big impact on the firm and its valuation as shares plunged from $60 to $6 between 2005 and 2008, before embarking on an impressive multi-year momentum run higher to current levels in the mid-fifties.
Investors might furthermore have some doubts about the size of the deal. Lennar has often made deals, but typically they have been rather small, as this large deal breaks this tradition. Integrating these two large businesses is a daunting task while demand for housing remains very strong.
Synergies will boost earnings by $165 million on an after-tax basis, once those synergies are fully realised. Lennar has roughly 233 million shares outstanding and will issue another 97 million shares to investors in CalAtlantic, for a total share count of 330 million shares, not baduming any cash payments to CalAtlantic. The $165 million additional after-tax earnings therefore lines up exactly with the expected accretion of $0.50 per share.
While Lennar’s third quarter results improved from $1.01 per share to $1.06 per share, earnings only came in at $2.13 per share in the first nine months of the year, down from $2.59 per share reported last year. The fall in earnings is mainly the result of a sizeable litigation charge. Adjusted for these charges earnings trend at levels closer to $4 per share per annum, as accretion could boost hits number to $4.50 per share. Trading at 12 times earnings the multiple is not very high, yet investors see little of these earnings as the dividend yield comes in at just 0.3%, while growth and acquisition of sites requires quite a bit of capital.
The negative response to the deal seems a bit like an overreaction given the expected earnings accretion, and low multiple. On the other hand, shares are up 30% year to date as leverage multiples will jump by 0.5 turns. While the deal will work out great if the housing market continues to see further traction ahead, leverage is a double sword if the market turns. In that sense investors should be relieved that the deal is mostly a an equity swap at fair prices, allowing both set of shareholders to benefit from the anticipated benefits of the deal.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.